Roth IRAs and prohibited transactions
When I retire in 2012, I’m planning to rollover over my 401(k) account to a traditional IRA then convert to a Roth. Since this will occur in 2012, I won’t be using the 2-year income averaging available for a 2010 conversion. After the conversion, I want to then invest my Roth funds in a real estate deal that will be available at that time. The investment could (but I don’t think it will) raise the issue of a prohibited transaction. My question is this: what’s the down side if the Roth investment does turn out to be a prohibited transaction? From what I read, it seems the main down side of an IRA prohibited transaction is that all of the IRA funds are treated as having been distriuted and are taxable to the IRA owner, but my conversion in 2012 from a traditional IRA to a Roth will already result in my paying income taxes on all of the IRA funds. Would a prohibited transacation mean that I have to pay taxes on the Roth funds a second time? Assuming that is not the case, then the only down side that I can see from a prohibited transaction is that the investment will no longer be seen as owned by an IRA for tax purposes so that any future gain on the investment will be taxable to me when realized, and conversely any future losses would be deductible to me on the same basis as if I personally owned the real estate investment. Anyone see this differently?
Permalink Submitted by Alan Spross on Mon, 2009-07-06 20:13
There is no second taxation. The downsides of a Roth prohibited transaction are:
1) Since the assets are no longer in the Roth, future tax deferral and tax free earnings are forfeited.
2) If you are under 59.5 on January 1st of the year of the prohibited transaction, the Roth conversion 5 year holding period will apply, meaning that the distribution will result in a 10% penalty to the extent it comes from conversions not meeting the holding requirement.
Also, note that taxation of a large conversion in 2012 might increase your marginal tax bracket for the year, and tax rates may also be higher than current rates, since all Bush tax cuts will have sunseted by then.
Would suggest rather than taking the chance, you locate the specialized IRA custodian you will need to hold real estate investments, and with their help determine how to avoid a prohibited transaction.
Permalink Submitted by James Houle on Mon, 2009-07-06 21:57
Thank you, alan-oniras, for your thoughtful reply. For your info, I’m over 59-1/2 (that’s why I’m retiring in 2012) so the possibility of a 10% penalty isn’t a concern. With regard to your suggestion that I find a specialized IRA custodian to assist me with structuring the real estate investment so that it’s not a prohibited transaction, I’ve actually talked to both an IRA custodian and a lawyer who claims to know about IRA investments. They both say that they don’t know “for sure” if the proposed real estate investment absolutely would escape being seen by the IRS as a prohibited transacation if I’m audited. Since I’m a belt-and-suspenders kind of investor, I want to know beforeheand what the worst case scenario might be. It seems you agree that the worst case is that I simply might lose the tax-deferred status of the Roth IRA but that I will not have to pay a second round of taxes on a deemed IRA distribution. So, if the investment turns out to be wildly successful but is a prohibited transaction, I’ll probably regret the loss of the IRA status, which would have allowed the gain to be nontaxable to me. On the other hand, if the investment turns out to be a real loser but I get to claim a personal capital loss deduction because it was a prohibited transaction, then maybe it’s not so bad after all, and in fact it would even beat having the Roth IRA hold the failed real estate investment since I cannot dedect loses realized by my Roth IRA.
Permalink Submitted by Alan Spross on Mon, 2009-07-06 22:15
Following is a link to a detailed article on prohibited transactions.
Note that in the event of a forced distribution, the Sch D tax basis of the Roth holdings are determined as of the day of distribution from the Roth IRA. Inasmuch as this is a Roth IRA, some of the concerns in the article about fair market value determinations in connection with RMDs will not apply, since a Roth IRA has no RMD requirement for owners, although there would be a problem if a non spouse beneficiary inherited the Roth from you and would face an RMD requirement and liquidity in the Roth to provide RMD funding.
Another scenario would occur if the holdings were profitable, producing Roth gains before the forced distribution. In the event that 5 years had not elapsed from your first Roth contribution, the distribution would be non qualified, and the earnings in the Roth would be taxable based on the value of the holdings on the date of forced distribution.
http://www.aba.com/NR/rdonlyres/D8BE9599-E5ED-4994-91CB-BF8B23A2AE7C/429…
Permalink Submitted by James Houle on Tue, 2009-07-07 14:01
Alan-iniras, with regard to the RMDs you mention, a discussion of RMDs seems relevant only if the real estate investment is not a prohibited transaction and therefore the Roth IRA continues to be a “good” IRA subject to the RMD rules. For example, if the original investment I’m planning to make in 2012 turns out to be a prohibited transaction that results in the Roth IRA losing its tax status and no longer being an IRA, then from that point forward no beneficiary will be subject to RMDs since there is no IRA. If on the other hand the investment turns out to not be a prohibited transaction, then the Roth IRA continues to maintain its status as an IRA and RMDs to beneficiaries are relevant. Event in that event, however, I think RMD distributions to beneficiaries after my death could be addressed by having the Roth IRA either distribute interests in the real estate investment to them or sell interests as needed (assuming the investment is somewhat liquid) and distribute cash.
Your second paragraph mentions that “another scenario would occur if the holdings were profitable, producing Roth gains before the forced distribution.” If by “forced distributions” you mean a deemed distribution from the Roth IRA due to the real estate investment being a prohibited transaction, then I don’t see that the normal 5-year Roth holding requirement applies. Rather, it seems that when the prohibited transaction occurs the Roth IRA would cease to be an IRA for tax purposes and from that point forward the real estate investment is treated as if I owned it directly for tax purposes. If this is correct, then there would be no continuing application of any of the Roth IRA rules, including any 5-year holding requirement. The only possible application that I can see for the 5-year holding requirement to my planned investment is if there is a gap in time between when I convert from a traditional IRA to a Roth IRA in 2012 and if it turns out that during the gap period there is some gain realized by the IRA before the real estate investment occurs as a prohibited transaction. In such a case the gain during the gap period could be additional taxable income to me due to a violation of the 5-year rule. In my case, the conversion from a traditional IRA to a Roth IRA will have no gap period since the motivating reason to do the conversion would be to invest immediately in the real estate deal.
Permalink Submitted by Alan Spross on Tue, 2009-07-07 20:38
It depends on when the prohibited transaction occurs. If the acquisition itself is prohibited, then there would be no gains in the Roth to be taxed. However, if the prohibited transaction occurs at a later date due to an element of handling the investment, the Roth could have gains by then and those gains would be taxable upon distribution. The IRA custodian must issue a 1099R showing a value upon distribution of the Roth, and if greater than the conversion amount, would be subject to tax.
Permalink Submitted by James Houle on Tue, 2009-07-07 21:31
What this exchange of ideas suggests to me are the following points:
(1) The prohibited transaction “nuclear bomb threat” of which most advisors warn (that is, that a prohibited transaction will result in an immediate deemed distribution of all IRA funds to the IRA owner) is a threat that has no real teeth when it comes to most Roth IRAs. This is because a Roth IRA investment that turns out to be a prohibited transaction will result in a deemed distribution of funds that generally are not taxable to the Roth IRA owner based on the rule that Roth IRA distributions are not taxable.
(2) Minor concerns regarding the 5-year rule for a converted Roth IRA, personal realization of capital gain for a successful investment (I should be so lucky!), etc. are either manageable or not of earth-shattering consequences.
If I’m understanding all this correctly, it seems the principle to be learned in all this is that if there is an attractive potential IRA investment which is one that raises some concern as a prohibited transaction, an added layer of protection against a significant tax disaster would be to make the investment through a Roth IRA rather than a traditional IRA.
Permalink Submitted by Alan Spross on Tue, 2009-07-07 22:01
Point 1 is correct, and is explained by the fact that only about 6% of all IRA assets are currently in a Roth IRA, and those Roth accounts tend to be smaller and less likely to hold real estate. Therefore, the financial press focuses on TIRA taxable distributions in the event of disqualification.
The last point is only partially true, since the Roth is mostly tax free only because taxes have been paid up front at contribution for the potential benefit of tax free gains in the future. If the tax free gains are never realized, then the tax bill was just accelerated. If the investment has good results, then holding it in the Roth for tax free gains is a winner vrs losing those opportunities through a prohibited transaction. Finally, remember that real estate held in taxable accounts receives a number of tax breaks including depreciation, tax deferral, LT cap gain rates and a step up at death. Accordingly, the tax benefits of tax free growth for real estate holdings might require twice the gain as an equivalent benefit of ordinary income property. For example, if the Roth held corporate bonds paying 7%, then real estate would have to grow at least 12% or so to produce the same total tax benefit.
The worst allocation decision would be holding the real estate in a TIRA, thereby converting tax preferences into ordinary income.
Permalink Submitted by Bruce Steiner on Tue, 2009-07-07 22:52
A traditional IRA doesn’t convert capital gain to ordinary income. It is best viewed as being part yours (100% minus the applicable tax rate) and part the government’s, with the income and gains on your share being tax-free.
But by putting into an IRA an asset that, if held in a taxable account would receive favorable income tax treatment, you’re giving up the opportunity for the favorable income tax treatment (if you had owned that asset in your taxable account).